Managerial accounting by garrison noreen13th appendix b

Profitability Analysis
Appendix B

McGraw-Hill/Irwin

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.


Absolute Profitability
Absolute profitability measures the impact on the
organization’s overall profits of adding or dropping
a particular segment such as a product or
customer – without making any other changes.

App B-2


Computing Absolute Profitability
For
For an
an Existing
Existing Segment
Segment
Compare
Compare the
the revenues
revenues that
would be
that would
be lost
lost from

from
dropping
dropping that
that segment
segment to
to the
the costs
costs that
that
would
would be
be avoided.
avoided.
For
For aa New
New Segment
Segment
Compare
Compare the
the additional
additional revenues
revenues from
from adding
adding
that
segment to
to the
the costs
be incurred.
that segment

costs that
that would
would be
incurred.

App B-3


Relative Profitability
Relative profitability is concerned with ranking
products, customers, and other business segments
to determine which should be emphasized in an
environment of scarce resources.

App B-4


Relative Profitability
Managers
Managers are
are interested
interested in
in ranking
ranking segments
segments ifif aa
constraint
constraint forces
forces them to make trade-offs
trade-offs among
among

segments.
segments.
In the
the absence
absence of aa constraint, all
all segments
segments that
that are
are
absolutely
absolutely profitable
profitable should
should be
be pursued.
pursued.

App B-5


Relative Profitability

Incremental
Incremental profit
profit from
from the
the segment
segment is
is
the
the absolute

absolute profitability
profitability of
of the
the segment.
segment.

Incremental profit from the segment
Profitability
=
index
Amount of the constrained
resources required by the segment

App B-6


Profitability Index
Management
Management of
of Matrix,
Matrix, Inc.
Inc. developed
developed the
the following
following
information
information concerning
concerning its
its two
two segments:

segments:

Incremental profit

Segment A

Segment B

$

$

Amount of constrained resource required
Profitability index

100,000
100 hours

$

1,000

200,000
400 hours

$

500

App B-7

Project Profitability Index
From Chapter 14

Project
profitability
index

=

Net present value of the project
Amount of investment
required by the project

The
The project
project profitability
profitability index
index is
is used
used
when
when aa company
company has
has more
more long-term
long-term projects
projects
with

with positive
positive net
net present
present values
values than
than itit can
can fund.
fund.
App B-8


Project Profitability Index
From Chapter 14

Project
profitability
index

=

Net present value of the project
Amount of investment
required by the project

The
The net
net present
value of
present value
of the

the project
project
goes
goes in
in the
since itit represents
represents
the numerator
numerator since
the
the incremental
incremental profit
profit from
from the
the segment.
segment.
App B-9


Project Profitability Index
From Chapter 14

Project
profitability
index

=

Net present value of the project
Amount of investment

required by the project

The
The investment
investment funds
funds are
are the
the
constraint,
constraint, so
amount of
of investment
investment
so the
the amount
required
required by
project goes
in the
the denominator.
by aa project
goes in
denominator.
App B-10


Quality Kitchen Design – An Example

Project A

Incremental
Profit

Constrained
Resource
Required

(a)

(b)

$

Profitability Index
(a) ÷ (b)

9,180

17 hours

$

540 per hour

Project B

7,200

9 hours

800 per hour

Project C

7,040

16 hours

440 per hour

Project D

5,680

8 hours

710 per hour

Project E

5,330

13 hours

410 per hour

Project F

4,280

4 hours

1,070 per hour

Project G

4,160

13 hours

320 per hour

Project H

3,720

12 hours

310 per hour

Project I

3,650

5 hours

730 per hour

Project J

2,940

3 hours
100 hours

980 per hour

App B-11


Quality Kitchen Design – An Example

Project A

Incremental
Profit

Constrained
Resource
Required

(a)

(b)

(a) ÷ (b)

9,180

17 hours

Project B

7,200

9 hours

800 per hour

Project C

7,040

16 hours

440 per hour

Project D
Project E
Project F
Project G
Project H

$

Profitability Index
$

540 per hour

If management
8 hours
710
only has
available,410
5,330 46 hours
13 hours
4,280 projects
4 hours
which
should 1,070
4,160
13 hours
320
be
accepted?
3,720
12 hours
310
5,680

per hour
per hour
per hour
per hour
per hour

Project I

3,650

5 hours

730 per hour

Project J

2,940

3 hours
100 hours

980 per hour

App B-12


Ranking Based on Profitability Index

The optimal profit
App B-13


Volume Trade-Off Decisions
Volume
Volume trade-off
trade-off decisions
decisions need
need to
to be

be made
made
when
when aa company
company must
must produce
produce less
less than
than the
the
market
market demands
demands for some
some products
products due
due to
to the
the
existence
existence of a constraint.

App B-14


Volume Trade-Off Decisions
Volume
Volume trade-off
trade-off decisions
decisions need
need to

to be
be made
made
when
when aa company
company must
must produce
produce less
less than
than the
the
market
market demands
demands for some
some products
products due
due to
to the
the
existence
existence of a constraint.

Profitability index
for a volume =
trade-off decision

Unit contribution margin
Amount of the constrained resource
required by one unit

App B-15


Pricing New Products
The price of a new product should at least cover
the variable cost of producing it plus the
opportunity cost of displacing the production of
existing products to make it.
Selling price
of new
product

≥

Variable cost
of the new +
product

Amount of the
Opportunity cost
constrained
per unit of the
× resource required
constrained
by a unit of the
resource
new product

App B-16

End of Appendix B

App B-17